When answering the questions below, refer to the following table and related data.
Project Cash Flow Tree From a New Project
$$\begin{array} { r r r }
\text { Year 1 } & \text { Year 2 } & \text { Year 3 } \
120.52 & 155.67 & 222.64 \
65.24 & \mathbf { 8 4 . 2 7 } & 120.52 \
& 45.62 & \mathbf { 6 5 . 2 4 } \
& & 35.32
\end{array}$$ Effective annual risk free rate = 4.5% Expected market return = 10%
Cash flow beta = 1.4
The true probability of the high cash flow in a given period is 52.0%.
-What is the risk neutral probability of the first two years of the project cash flows moving down?
A) 40.3%
B) 48.0%
C) 52.0%
D) 59.7%

Question

When answering the questions below, refer to the following table and related data.
Project Cash Flow Tree From a New Project
 $$\begin{array} { r r r } 
\text { Year 1 } & \text { Year 2 } & \text { Year 3 } \
120.52 & 155.67 & 222.64 \
65.24 & \mathbf { 8 4 . 2 7 } & 120.52 \
& 45.62 & \mathbf { 6 5 . 2 4 } \
& & 35.32
\end{array}$$ Effective annual risk free rate = 4.5% Expected market return = 10%
Cash flow beta = 1.4
The true probability of the high cash flow in a given period is 52.0%.
-What is the risk neutral probability of the first two years of the project cash flows moving down?
A) 40.3%
B) 48.0%
C) 52.0%
D) 59.7%

Quizplus · Accepted Answer

The risk-neutral probability is calculated using the formula: p* = (1 + r - d) / (u - d), where r is the risk-free rate, u is the up factor, and d is the down factor. Given the cash flow beta and market return, the risk-neutral probability for the cash flows moving down is 40.3%.

When Answering the Questions Below, Refer to the Following Table